Understanding principal reduction: What it is and how it helps homeowners

Many homeowners experience hardship and run into scenarios where they can’t afford their mortgage. Principal reductions were an option for homeowners who had negative equity (owing more on your home than what it’s worth).

Here, we’ll define principal reduction and cover its history. Since principal reduction programs have ended, we’ll also cover alternatives if you’re experiencing negative equity or having a hard time paying your mortgage.

What is principal reduction?

A principal reduction lowers the total principal balance a borrower owes on their mortgage. Provided to homeowners with underwater mortgages (another term for negative equity) in the wake of the subprime mortgage crisis, principal reductions were designed to help both the borrower and lender avoid the foreclosure process.

A principal reduction was an alternative to foreclosing on a home, since no one benefits from a foreclosure. Because many people were defaulting on their loans following 2009, programs were introduced to reduce the principal owed to keep homes out of foreclosure.

Principal reductions and the subprime mortgage crisis

Principal reductions came out of the 2008 – 2009 financial crisis caused largely by the housing bubble of subprime mortgages. These mortgages were called “subprime” because they were given to borrowers with low credit scores. It resulted in many people getting in over their heads on homes they couldn’t afford.

As people started to default on their mortgages, the growing real estate bubble burst. Housing prices plummeted, which left many people with negative equity. In response, the U.S. government created a program called the Home Affordable Modification Program (HAMP) and other principal reduction programs.

Principal reduction programs

Let’s review the principal reduction programs that helped homeowners facing problems with paying their mortgage. These programs were started in the wake of the housing market crash and have since expired.

Home Affordable Modification Program (HAMP)

HAMP was a federal loan modification program announced after the subprime mortgage crisis in 2008 as part of the U.S. government’s Troubled Asset Relief Program (TARP). Fannie Mae and Freddie Mac joined in the second quarter of 2009 to implement HAMP.

A few of the requirements to qualify for HAMP were:

• Mortgages needed to have an unpaid balance of less than $729,750.
• Property could not be condemned or uninhabitable.
• Debt-to-income ratio (DTI) must meet standards showing financial hardship.

HAMP ended in 2016.

Hardest Hit Fund (HHF)

The U.S. Treasury created the Hardest Hit Fund (HHF) in 2010. It was established to provide aid to the states most affected by the subprime mortgage crisis. The HHF was available to 18 states and the District of Columbia.

Many of the states used this fund to create their own programs, like Keep Your Home California and Step Forward Michigan. Each state had their own requirements for eligibility, with a common requirement being that the home be the primary residence in the state the program was located.

In 2016 when HAMP ended, Congress increased funding to HHF, making it available through 2020.

Principal Reduction Modification

The Principal Reduction Modification program was a one-time program announced by the Federal Housing Finance Agency (FHFA) in 2016. To qualify, borrowers had to be at least 90 days delinquent and have an unpaid principal of $250,000 or less, among other eligibility criteria.

The program was offered only to borrowers with Fannie Mae or Freddie Mac loans. It ended in October 2016.

Mortgage principal reduction eligibility

While principal reduction programs are no longer available, general mortgage payment assistance may be. To be eligible, your property needs to be distressed or in danger of foreclosure.

Most of these programs have limits on the amount of principal you can owe and require the property to be your primary residence. If a principal reduction is an option, you need to prove you’ll be able to afford your mortgage payments with the principal reduction.

Following the ending of HAMP and the principal reduction modification in 2016 and the HHF in 2020, opportunities for principal reduction have become rarer. So, let’s go over some alternatives.

Alternatives to principal reduction

If you’re struggling with negative equity or making your monthly payments and are ineligible for or can’t find a principal reduction program, here are some other options:

• Build up equity. If you’re gainfully employed but are underwater in your mortgage, staying in your home and building equity through regular or extra payments can help.
• Refinance for a lower monthly payment. A rate and term home loan refinance could help you reduce your monthly payment. If you can refinance to a lower rate, this could save you money on a monthly basis and over the life of the loan.
• Seek out a loan modification. A loan modification is a change to your original terms and structure of your mortgage. While a loan modification may seem like a refinance, the differences are that you have to apply for a loan modification with your lender, you don’t pay for it and it could negatively affect your credit score.
• Look into loan forbearance. If you’re having trouble paying your mortgage, you may be eligible for loan forbearance from your lender. Loan forbearance puts a temporary pause on payments due to a short-term hardship. Contact your lender to see if you qualify.

The bottom line

Principal reduction was a tool used to help homeowners who were underwater in their mortgage and had a hard time making payments as a result of the 2008 subprime mortgage crisis. The two major federal programs, HAMP and HHF, have since ended.

However, plenty of options are still available for homeowners who have negative equity or are having trouble paying their mortgage. If you’re struggling to pay your mortgage on time, consider applying to refinance your loan today.